Postdicting the meltdown
My column in yesterday’s Fin started with the observation “The pace of events in financial markets has been so rapid that any projection of events in the short term seems likely to be obsolete soon after it is printed.”
Ignoring my own advice, I wrote a piece yesterday for Crikey (over the fold) which included the prediction “The largest remaining savings & loan firm, Washington Mutual is unlikely to survive into next week, with the most likely outcome one involving a large scale default on its mortgage obligations.” By the time it appeared today, it was a postdiction.
The casualty list from the stunning events of the last few weeks on Wall Street is an impressive one. In this short space of time, the US Administration has effectively nationalised the main mortgage guarantors, Fannie Mae and Freddie Mac and the worldâ€™s largest insurance company, AIG. The massively profitable Wall Street investment banking industry has ceased to exist, with Lehmans bankrupt, Merrill Lynch sold and Goldman Sachs and Morgan Stanley seeking the safety of commercial bank status. The largest remaining savings & loan firm, Washington Mutual is unlikely to survive into next week, with the most likely outcome one involving a large scale default on its mortgage obligations.
The reputational damage is equally severe. The Bush Administrationâ€™s place as the worst in US history has been cemented, with a financial and economic disaster to match the Iraq catastrophe. Alan Greenspan, whose policies were responsible for the current mess, was still being treated as an elder statesman a few weeks ago, but his reputation is gone for good now. And Henry Paulson and Ben Bernanke look set to follow a similar path, as their $700 billion bailout plan is exposed as a massive example of rentseeking.
But there is much more to come. Assuming (a big assumption) that the Democrats hold their nerve, any bailout will require the public to be compensated with equity for any losses they incur on the purchase of mortgage-backed securities and similar toxic sludge. Since such losses are inevitable if the plan is to have any real benefits, the result will be a further extension of public ownership, to include a substantial number of the main commercial banks.
No doubt, when the crisis is over, these businesses will return to the private sector. But itâ€™s hard to believe (as most financial commentators seem to be supposing) that things will rapidly return to something like the situation prevailing before the crisis began. For a start, large areas of financial activity (auction rate securities, CDOs, subprime mortgages, monoline bond insurance) have collapsed, and seem unlikely to re-emerge. The massive market in credit default swaps will almost certainly be shut down, and the even larger interest rate swap market is likely to be scaled back to levels where financial regulators can manage it. Reductions in executive pay have already been accepted as a bailout condition, and it will be a long time before they are reversed.
Going beyond these obvious casualties are the implications for economic and political theories. The efficient markets hypothesis, badly wounded by the dotcom fiasco a decade ago, must surely be discredited now. The most sophisticated financial markets the world has ever seen have produced a situation where securities depending ultimately on debts owed by people with neither income, assets nor any incentive to repay have been treated as if they were (quite literally) as good as gold.
More generally, the whole free-market ideology variously referred to as economic rationalism, neoliberalism or the Washington Consensus, is in serious trouble, at least as regards the role of financial markets. The central element of financial neoliberalism is the claim that modern global financial markets can do a much better job of managing risks than can national governments. Given the array of sophisticated financial products available to individuals and households, for example, it is assumed to be much better to rely on markets to provide retirement income than on public pension schemes.
The neoliberal view is the polar opposite of the Keynesian social democratic view, informed by the experience of the Great Depression. In this view, not only are governments the ultimate risk managers, but financial markets are part of the problem not part of the solution. While being necessary to mobilise private investment in a mixed economy, financial markets are seen, in the Keynesian view, as being inherently prone to destabilising speculation, which can induce large-scale macroeconomic failures.
The events of the last few weeks represent a striking failure of the neoliberal position. Although large-scale financial crises have been commonplace since the breakdown of the Bretton Woods system of financial controls in the 1970s, they have mostly taken place in the periphery of the global economy.
The debt crisis of the 1980s affected mostly the poorest developing countries. The crises of the 1990s hit middle-income countries in Asia, as well as Mexico, Argentina and Russia but had little impact on the main OECD countries. And, while the dotcom boom and bust can be seen in retrospect as a warning that the US was not immune to similar crises, the warning was ignored. Greenspan postponed any real adjustment with easy money and lower interest rates. Even the very modest responses that were made, such as the Sarbanes-Oxley act were soon being derided as an over-reaction.
Thatâ€™s not possible this time. The losses are so great that they threaten to bankrupt most of the major remaining financial institutions in the US. And even if the original plan of a bailout without any compensating equity stake were politically feasible, itâ€™s no longer economically sustainable. The foreigners on whom the US is depending to finance the bailout are already losing faith. A massive handout would raise a large risk of extending the panic from the financial sector to the US government as a whole.
So, there is no alternative to a drastic cutback in the size and power of the financial sector and to a return to reliance on government as the ultimate risk manager. The events of the past few weeks have been so rapid that people have had little time to absorb them, let alone adjust their world views. But, as time passes, it will become steadily more evident that the day of neoliberalism is done.